Have you ever heard a story that so profoundly affected you that it changed your entire point of view? I'm sure you have. There are all sorts of tall tales of investing: of fortunes won and lost, of Rule Breakers and Rule Makers, of small-cap skyrockets and deeply hidden values. Of all the stories I've heard in my investing career, the one that inspires me most features Benjamin Graham, founder of value investing and mentor to Warren Buffett.
Graham emigrated from England with his family when he was barely a year old. He grew up in Manhattan and Brooklyn and went on to Columbia University, from which he graduated in 1914. Though he had an opportunity with the family business, Graham instead opted for a career on Wall Street. By 1920, he was a partner at a major securities firm. Six years later, he formed the Benjamin Graham Joint Account, an investment fund he ran with partner Jerome Newman. But hard times would follow. From 1929 to 1932, the Joint Account declined by a breathtaking 70%.
But there was more bad news to come. It turned out that Graham had used substantial margin in making his selections. So when the stock market crashed, the massive debt he had incurred to buy stocks suddenly came due. That borrowing nearly ruined him.
Graham persevered by selling personal assets and taking out loans with friends and family. Over the next 30 years, he and Newman would deliver 17% annualized returns to investors in the Joint Account. That's a remarkable record by any measure, and it's well north of the stock market's historical annual average return of 10%.
Graham never recounts this story in his landmark work, The Intelligent Investor, but the lessons he learned over 30 years of making money for others spring forth from every page. Here are two that continue to serve me well in my own investing.
Lesson No. 1: Buying stocks makes you an owner
My favorite part of The Intelligent Investor comes toward the end, in the section that covers shareholder rights and responsibilities. Graham exhorts common stockholders to think of themselves as owners who have a right to answers. He writes: "Shareholders are justified in raising questions as to the competence of the management when the results (1) are unsatisfactory in themselves, (2) are poorer than those obtained by other companies that appear similarly situated, and (3) have resulted in an unsatisfactory market price of long duration."
In other words: If your investment is underperforming, you have every right to demand better. On more than one occasion, Graham did exactly that. Consider this tidbit from another wonderful investing work, John Train's Money Masters of Our Time: While combing through Interstate Commerce Commission filings in the mid-1920s, Graham found that Northern Pipeline had $95 per share in assets. The stock, however, was selling for $65 per share and yielding 9% at that price. Graham jumped at the opportunity. At the 1928 annual meeting, he garnered 38% of the proxies and was named to the company's board of directors. In that position, he would help persuade Northern Pipeline to pay out a huge $50-per-stub distribution to shareholders, clinching his original valuation thesis.
Graham considered management to be the stewards of stockholder money. Company managers were to invest intelligently and create market-trouncing returns or, in lieu of that, earn enough to pay a steady, growing dividend. He also expected them to possess a high degree of competence and ethical behavior.
Graham would never stand to be a victim of corporate shenanigans, such as the never-ending options backdating scandal that still plagues Apple (Nasdaq: AAPL ) , Altera (Nasdaq: ALTR ) , Monster Worldwide (Nasdaq: MNST ) , and Sapient (Nasdaq: SAPE ) , among others. Nor would he have been a victim of the apparent fraud that's brought formal SEC charges against executives of ailing auto-parts maker Delphi.
He'd instead have taken action, as an owner should. It is because of Graham's teachings that today I take proxy season as seriously as I take any national election. You should, too.
Lesson No. 2: Always buy with a margin of safety
Graham was perhaps the first stock analyst to understand that in investing, price is everything. Indeed, buying shares of a great company means nothing if you overpaid. And buying rubbish on the cheap will frequently leave you with only the unpleasant odor of a rotting portfolio.
Graham details how to buy with a margin of safety, which he calls the "central concept" of investing. Put simply, the margin of safety is the difference between intrinsic value and the price at which a stock trades. For example, a security worth $50 per share but trading at $25 per share enjoys a massive 100% margin of safety. Buying in that situation heavily stacks the odds in the investor's favor.
Conversely, a stock that trades close to or above its intrinsic value offers almost no margin of safety. And buying without a margin of safety, in Graham's book, is no better than mere speculation.
Consider overhyped ethanol producer Aventine Renewable Energy (NYSE: AVR ) , which is rated as one of the 10 worst stocks in Motley Fool CAPS and which yesterday reported a decline in third-quarter earnings that cut the stock price by nearly 13%.
Or think of biotech Discovery Labs (Nasdaq: DSCO ) , which is struggling to earn approval for its potentially life-saving drugs as it restructures loans. No wonder the shares have fallen by 67% over the past 52 weeks.
That's why seeking a substantial margin of safety can light the path to outsized returns. It has certainly helped Philip Durell, lead analyst for Motley Fool Inside Value. Take his investment in retailer Dollar Tree (Nasdaq: DLTR ) , for example. When Philip recommended it in the August 2005 issue, the stock enjoyed a 30% margin of safety. Subscribers who followed his advice are up more than 25% as I write.
The Foolish bottom line
I've read and re-read my copy of The Intelligent Investor; it's lined with yellow highlighter ink. Reading that book was one of the most important steps I took toward developing a lucid investment strategy. And I believe Buffett was right when he called it the "best book on investing ever written." Now, we're prepared to give it to you for free.
Sign up for a one-year subscription to Inside Value, and you'll get the book and full access to a service that has outperformed the S&P 500 since inception. We'll refund your money in full within 30 days if you're not completely satisfied, and you can cancel at any time without obligation. That's a margin of safety any Fool can appreciate.
This article was originally published on May 31, 2005. It has been updated.
Fool contributor Tim Beyers breaks the rules in his portfolio from time to time, but he also appreciates a good value as much as any Fool. Tim didn't own stock in any of the companies mentioned in this story at the time of publication. Get the skinny on all the stocks in Tim's portfolio by checking out his Fool profile.The Motley Fool's disclosure policy is always a value.